We Walk The Line

Interpreting Fed Policy Action and Implications for Treasury Yields

Hawkish? Dovish? Even more dovish? Hawkish?

The interpretation of Federal Reserve policy intent by financial market participants has pirouetted across the stage of the past nine months, partly in response to the discordant score played by officialdom. The cacophony is such that the rate calls of many prominent investment firms have violated a fundamental tenet of forecasts: Projections are supposed to be less, not more, volatile than that projected.

The Standish view is that, while Fed communication may be convoluted, Fed intent is plain. Monetary policy makers want to renormalize their interest-rate stance. They thought they set off a gradual tightening regime at the end of last year only to learn that four quarter-point rate hikes in 2016 seemed dangerously outsized to market participants. At its March meeting, the Federal Open Market Committee (FOMC) stretched out its plan to encompass only two moves this year. Subsequent central bank talk was meant to reassure investors, themselves, and tomorrow’s historians of the Fed that following a glacial path that was without US precedent was warranted and that, in any circumstances, the plan depended on the outlook. Many market participants double counted, taking the attempt to justify a dovish decision as predicting even more dovishness in future decisions.

Fed talk since has made it plain that two tightenings are penciled in for 2016. The rest of the real estate of this note explains what this implies for Treasury yields. Notwithstanding Chair Yellen’s admonishment that “one should not look to the dot plot…,” the surprising finding is that a lot can be learned from taking the Fed at its word, or its dots. 1 We price out the Fed’s rate guidance since it has been providing guidance in the Summary of Economic Projects (SEP), from January 2012 to March 2016. The Fed’s intended path of policy tightening is shallower than last year and has them settling out at a funds rate that is lower than previously indicated, but policy makers are tightening now, rather than just suggesting future action. Walking their rate guidance forward (dropping the promise of policy staying on hold from 2012 to mid-2015 to living the prospects of more immediate action) explains a bit of the movement in the Treasury yield curve, especially a relative flattening at the longer end. The exercise also highlights that a major disconnect between the Fed and market participants opened in 2014. Thinking about the origins of that wedge helps identify the five main alternative scenarios in store for investors over the next several years. The Fed may be right or wrong. Whether it is right or how it is wrong matters materially for portfolio choice.

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